Prompted by the emergence of new triggers, business interruption remains a top risk according to the 2017 Allianz Risk Barometer, which defines it as “a loss of income that could impair a company’s revenue stream and thus [trigger] a shortfall in covering the ongoing costs of doing business.” Given the nature of business interruption losses and the impact they can have on an organization, they can be quite difficult to measure.
Due to globalization and shifts in market trends and demands, triggers of business interruption losses are expanding from traditional damage-driven events, such as natural catastrophe or fires, to newer, formerly uninsurable events. Such events include cyber incidents and access restrictions to areas impacted by terrorism or political violence, both of which can result in a large loss of income for companies. Managing a business interruption claim can be a challenging exercise, and understanding the complexities in mitigating business interruption losses is key to implementing effective pre- and post-event risk management strategies.
Jay Strano, Managing Director, Crawford Forensic Accounting Services
Within the context of a business interruption, a forensic accountant can be leveraged to quantify a loss through reviewing and analyzing the insured’s financial statements, past performance and business trends and prepare a business interruption analysis that coincides with the language of the policy coverage to indemnify the policy holder for covered losses in an expeditious manner.
Reviewing coverage – Sifting through terms of a general policy
Although policy wordings differ between insurers, business interruption coverage typically covers short-term financial losses (typically 12 to 24 months) arising from the interruption of a business’s operation resulting from insured physical damage to property of the type insured. Coverage can extend to include access to a premises and interruption of the supply of goods or services (contingent business interruption).
Like all coverages, business interruption policies are subject to typical time element exclusions, such as business losses due to strikes, breach or lapse of leases, penalties, etc. Understanding the full scope of the business interruption insurance in place is key to executing an effective loss cost containment strategy. An aspect of this is understanding policy definitions, two of which are indemnity period and measure of recovery.
Indemnity period refers to the period of insurance protection, commencing on the date of the event or damage and ending at the time defined in the policy. This is a component of the coverage that a forensic accountant can help the insured understand. Generally, an indemnity period will end with either the length of time to rebuild, repair, or replace, or when the business returns to normal operations, again depending on the policy wordings.
Gross earnings wordings generally use the period to rebuild, repair, or replace while gross profits wordings are generally used when the business income returns to normal. Although superficially similar, the difference in wordings can greatly affect the indemnity period.
In the case of physical damage, the length of time to repair, replace, or rebuild is just that. The indemnity begins when the damage strikes, and ends when the last nail is hammered in. However, once the repairs are finished and the business is operational, it may take some time for the normal course of business to resume. The indemnity period continues after the physical damage is repaired, replaced, or rebuilt, until when the actual income of the business matches a forensic accountant’s projection.
Working with the insured, a forensic accountant can analyze current sales and historical trends to develop an accurate projection on which to base the loss. Of course, there is also a time period limit in place, usually 12 months, but occasionally 18 or 24 months.
Measure of recovery
The insured is eligible to recover its loss of gross profit, or whatever measure is defined by the wording, produced by applying the rate of gross profit to any reduction in turnover caused by the physical damage. Once the forensic accountant has received and reviewed the financial statement, they can calculate the rate of gross profit. Previous claim experience allows the forensic accountant to quickly determine which parts of the financial statements will be included in calculating the rate of gross profit. Also, their experience allows them to work with the insured to develop and project the reductions in turnover against which the rate of gross profit will be applied.
Understanding the financial statement
Business interruption insurance is intended to cover the unavoidable fixed costs and loss of profit in the event of an unexpected loss of sales or revenue due to physical loss or damage of insured property. In order to determine actual loss sustained, it is necessary to review the insured’s income statement for the last completed fiscal year or 12 months prior to the date of loss.
Determining fixed and variable expenses is necessary and essential to determine the gross profit rate. Fixed costs include rent, where an abatement does not exist, while variable costs include things such as purchases and credit card fees, or any expenses which can be avoided if the business is suddenly suspended.
When the business is closed for an extended period of time, some costs may straddle the line between fixed and variable costs. These are described as semi-variable costs. As an example, utilities will generally stay stable during a short loss, however, for longer interruption periods, power usage may fall.
Forensic accountants are able to work with the insured to gather the necessary documentation to determine which, if any, expenses continue during the loss period. As a result, both the insured and insurer are involved in the process and have an understanding of how the rate of gross profit is calculated and what of the continuing expenses are covered.
Extra expense insurance is often added as additional coverage to a standard business interruption policy. Extra expense insurance covers additional costs in excess of normal operating expenses that the insured incurs to continue operations while its insured property is being repaired or replaced after having been damaged by a covered loss. These costs can include temporary property rental to set up operations and rental of equipment, such as portable generators to continue partial operations.
Extra expense insurance allows the insured to spend in excess of any amount it will save on the loss of gross profits. As an example, failing to meet contracts and deadlines may result in a loss outside the original insured loss, and a reasonable extra expense may help the insured save clients and future revenues.
Getting a handle on a business interruption claim starts well before the event takes place. By taking control of the data, establishing a team and developing plausible business interruption risks before losses occur, risk managers can do much to lessen the confusion and frustration common to the claims process. If it is done well, the business interruption process can be quite straightforward.
Jay Strano, CPA, CMA, is Managing Director, Crawford Forensic Accounting Services / Global Technical Services with Crawford & Company (Canada) Inc. •